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A recent judgment from the British Columbia Court of Appeal provides insight on the interpretation of exploration option agreements. This decision is part of protracted litigation between the parties, American Creek Resources Ltd. (American Creek) and Teuton Resources Corporation (Teuton). The significance of the case relates to the definition of “exploration expenditures” in option agreements.

Background and finding

Exploration option agreements are common in the mining industry. They typically involve a company that holds a mineral property (the optionor) granting a second company (the optionee) the option to earn an interest in the property by, among other things, exploring the property. The amount of exploration is typically measured in dollars spent—or “expenditures incurred”—by the optionee. The optionor typically holds the property (ultimately owned by the government) subject to a similar obligation to incur and report a prescribed amount of exploration expenditures. To cut out the middle person, option agreements commonly provide for the optionee to assume this obligation by reporting its exploration activities and expenditures directly to the government. The government will accept such a report if it satisfies the legislative requirements, including as to what constitutes exploration.

In this case, American Creek as optionee was entitled to acquire a 51 percent interest in a property held by Teuton, as optionor. To exercise the option, American Creek agreed to incur certain exploration expenditures on the property and to report the same to the provincial government. The period during which American Creek was to conduct exploration spanned 2007 to 2009, which were turbulent years in the mining industry (as in others). In 2007, exploration equipment and experienced personnel were in heavy demand. By 2009 the industry was subdued.

American Creek purported to exercise the option by giving notice in 2009 that that it had incurred and reported the required expenditures. Although the government had accepted the exploration reports, Teuton refused to transfer the 51 percent interest on the basis that some of the expenditures were unreasonable. As an example, Teuton cited the cost per meter drilled by American Creek, which was almost three times as high in 2007 as in 2009.

The Court found for American Creek because the obligation to make exploration expenditures does not include a standard of “reasonableness.” Moreover, since each mineral project has its own challenges, even if the agreement had required American Creek to incur expenditures on a reasonable basis, it would be difficult for Teuton to show that that standard was not observed.

Impact on mining industry

This case sets a positive precedent for optionees. It clarifies that, in order to meet its exploration obligations under a standard option agreement, an optionee must show that it has incurred expenditures in good faith regarding exploration of mineralization at the property. For an optionor to challenge any claimed amounts, it must show that the expenditures were not incurred in good faith, were wrongly calculated or attributed, or were not incurred at all. If governmental reporting is required under applicable legislation, those reports will likely be relevant in showing whether the expenditures were incurred and whether they relate to exploration.

The decision also acknowledges that optionees bears many risks, including the weather, geology, financial markets, and availability of professionals, personnel and equipment. These risks incentivize optionees not to perform carelessly.

Editorial comments and takeaways

Based on the findings of this case, we have outlined some observations that exploration companies should bear in mind when preparing option agreements.

Optionees should attempt to resist constraints on their ability to incur exploration costs as they see fit.

Optionors (and courts) should grant latitude to junior exploration companies in assessing whether expenditures constitute exploration expenses, particularly in the absence of an explicit qualifier such as “reasonable”. They should “avoid employing all the advantages of hindsight” in assessing an optionee’s conduct.

In British Columbia, the Mineral Titles Branch assessment process provides a baseline of reliability and efficacy that parties agree to accept under an option agreement when using the term “exploration expenditures”. In other jurisdictions, the applicable provincial or territorial legislation may serve the same purpose.

Helicopter and drilling cancellation fees may be claimed as exploration expenditures, particularly in the absence of an explicit standard of exploration practices, such as “reasonable” or “prudent”.

When it comes to mineral exploration, each project is different. To establish an industry standard, expert evidence must not present ideal practices or just the expert’s way of doing things. Even if reasonableness were the standard, it would be difficult to conceptualize.

When preparing option agreements, optionors should insist that exploration expenditures be incurred pursuant to a certain standard, such as reasonableness, or by reference to “Canadian Exploration Expenses”, as defined in the Income Tax Act. The best practices set out by the Canadian Institute of Mining can be included in agreements when appropriate, though they may carry risk. Optionors could also include objective conditions as criteria for determining the level of expenditures, such as requiring a certain amount of drilling, geophysical or geochemical work.

Conclusion

Mining and exploration companies entering into option agreements should qualify what constitutes “exploration expenditures”, or risk being subject to a court’s interpretation of that term in light of the parties’ performance. Under a standard option agreement, expenditures have to be incurred in good faith, but need not be reasonable if governmental reporting is required and accepted under applicable legislation. Optionors and optionees should seek advice on using the term “exploration expenditures”.

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